Sunday, April 18, 2010

A long post by Michael Pettis's about how China dealt with a banking crisis ten years ago, and how that crisis continues to affect economic policy serves as an interesting primer on the interaction of economic policy, banking, and the production and dissemination of real wealth. More specifically, it's a window into the tradeoffs between wealth production and wealth distribution. The basic premise is that someone always pays for a banking crisis even when GDP growth is not long interrupted.

Following the crisis, Pettis recounts, the Chinese government made the banks subsidize distressed lenders (by offering loans at very low rates) and in turn recapitalized the banks. Pettis' main focus is on a third step -- forcing depositors (i.e., ordinary Chinese households) to subsidize the banks:

Finally and most importantly, the third way of cleaning up the banking crisis involved the central bank mandating a wide spread – probably around 1.5 to 2.5 percentage points more than the normal spread – between the bank lending and the deposit rate, which increased bank profitability substantially and so helped to recapitalize the banks. In other words not only were depositors “taxed” for the clean-up by having to fund the very low lending rates, but they were taxed a second time to guarantee sufficient bank profitability to rebuild capital. With all these transfers from the household sector to the banks, amounting to several percentage points of GDP every year, households were forced to clean up the Chinese banking system.

A decade later, consumption in China remains crimped because individual Chinese can't get a fair return on their investment. Interest rates average 6% while growth rates average 14%, which means that households give up wealth to "owners of businesses, speculators and the government." Who in turn create new wealth, if unevenly shared.

There's interesting overlap between this chronicle and Gretchen Morgenson's examination in today's Times of the hidden costs of the U.S. bank bailout of 2008-09. These include a similar squeeze on depositors:

A major factor missing from Treasury’s math is the vast transfer of wealth to banks from investors resulting from the Fed’s near-zero interest-rate policy.

This number is not easy to calculate, but it is enormous. The Fed’s rock-bottom interest-rate policy bestows huge benefits on banks because it allows them to earn fat profits on the spread between what they pay for their deposits and what they reap on their loans. These margins are especially rich on credit cards, given their current average rate of 14 percent and up.

Perhaps that cost to individual investors in the U.S. has been somewhat offset by the enormous runup in the stock market since March 2009, and by the decent return yielded by bond funds over the same period -- not to mention extremely low interest rates for borrowers who can find a bank to lend to them.

To return to Pettis and China: the crunch on consumption in China, exacerbated by the last bank cleanup and the policies that persisted in its wake, create policy constraints that in some ways are the mirror image of constraints faced by the U.S. In the U.S., overindebtedness makes it difficult and dangerous to stimulate consumption, the traditional engine of recovery. In China, an economy overheated by massive stimulus has raised the risk of a new banking crisis -- which the government would likely cope with by once again squeezing consumption. Pettis concludes:

It turns out that banking crises might not be costless, even if they don’t lead to banking collapses. In the case of China they may instead lead to a collapse in consumption growth. As part of the trade dispute that China is facing with the rest of the world, this should give some indication of how little room China has for its adjustment. Anyone who is too impatient with the glacial pace of Chinese adjustment must recognize just how difficult it will be for China quickly to reorient its economy towards household consumption. The risk is that China, like Japan in the 1990s, will rebalance in the form of a sharp contraction in GDP growth as households struggle to pay for the misallocated lending boom.

For China as for the U.S., rebalancing the world economy is the most delicate of balancing acts.

UPDATE 4/20: In today's Times (and yesterday's, online), William D. Cohan, provides a sharper snapshot of the extent to which bak rescue in the US has come at the expense of depositors as well as taxpayers:

The easiest and most profitable risk-adjusted trade available for the banks is to borrow billions from the Fed — at a cost of around half a percentage point — and then to lend the money back to the U.S. Treasury at yields of around 3 percent, or higher, a moment later. The imbedded profit — of some 2.5 percentage points — is an outright and ongoing gift from American taxpayers to Wall Street.

You’re welcome.

And now for the truly obscene part. By keeping interest rates so stubbornly low — and by remaining committed to doing so — the Fed is crushing the rest of us, especially senior citizens on fixed incomes and those who have rediscovered saving in order to have some peace of mind.

For instance, despite my bank calling it a “premier platinum savings” account, I am getting a measly 0.15 percent interest rate. On my “premier platinum checking” account, the interest rate is 0.01 percent. In an essay in The Wall Street Journal recently, Charles Schwab pointed out that there is more than $7.5 trillion in American household wealth stored in short-term, interest-bearing checking, savings and CD accounts. (The average interest rate for a one-year CD is 1.3 percent.)

Our savings is another source of virtually free capital for banks to use to lend out at much higher rates. These anemic yields are a “potential disaster striking at core American principles of self-reliance, individual responsibility and fairness,” Mr. Schwab observed correctly.